Will heatwaves burn through energy resources?

Utility companies are warning customers to reduce their electricity use as temperatures across the world reach record highs. While these companies are regulated and hence incentivized to invest in their resources, increasing supply year round would lead to increased prices for customers, says the UBS Chief Investment Office (CIO). They maintain their neutral view of US utilities, but highlight that utilities’ infrastructure investments will help support stable earnings growth for US utilities.

Heatwaves are raging across Europe and Central and Southwestern US. The UK hit its highest recorded temperature of 40.2C (104.36F), and extreme heat warnings were issued in France as wildfires forced thousand to evacuate their homes.

Stateside, roughly 40 mn Americans are under heat warnings due to potentially record-breaking temperatures. Utility companies have warned US customers that power use is expected to reach all-time highs this summer, which could strain electric grids, according to Reuters. During a mid-May heatwave in Texas, six power plants experienced outages. At the time, Texans were urged by electric system operator Electric Reliability Council of Texas (ERCOT) to reduce their energy use, says The Guardian. They’re being asked to do so again.

As extreme weather events, such as storms, wildfires, and droughts, become more common, power use is expected to continue to grow and potentially reach all-time highs in the US this summer. This may strain electric grids for utility companies already facing supply-chain issues that make it difficult to get some equipment necessary to restore power in the case of an outage.

In addition, they are having a tough time rebuilding natural gas stockpiles for the upcoming winter. This is due to power generators burning record amounts of gas following the shutdown of dozens of coal plants in recent years and extreme droughts cutting hydropower supplies in many Western states, as noted by Reuters.

“The electricity distribution and transmission infrastructure is aging, but utility companies have an incentive to invest in it, and they continue to invest, while making sure their customers’ bills don’t increase too significantly on an annual basis,” says James Dobson, Energy Sector Strategist, CIO, UBS Americas.

“The challenge in Texas and elsewhere is on the supply side,” he added. “Electricity supply and demand must be equal to keep the system balanced. That’s the root of the issue. Demand is growing, yet coal plants are running less, renewables like wind and solar that can have variable output has grown significantly, so there is more strain on the supply side. Utility companies want to invest in their resources to provide reliable supply. In fact, they’re incentivized to do so through state and federal regulation. The challenge is that they don’t want to invest too much because it could make year-round electricity more expensive for their customers.”

“A utility company could invest enough to plan for one hot July day, but customers wouldn’t need those resources during other times, and it would be more expensive year round. We want utility companies to continue to invest in their infrastructure and have adequate supplies but there should be a cost-effective balance. Like many energy supplies around the world, there is a need to balance reliability, affordability and decarbonization, simultaneously.”

While utility company valuations are slightly elevated relative to the S&P 500, they have very stable earnings and earnings growth given the regulated nature of their business and the important resource they provide—electricity, says Dobson. He maintains his neutral view of US utilities. This view is supported by CIO’s positive view of the S&P energy sector, which remains premised on rising US production of oil and natural gas, a tight global supply and demand balance for oil and natural gas, ongoing capital discipline which supports increasing shareholder returns, and attractive valuation.

For more on the energy sector, reach out to your Financial Advisor for copies of the reports US Equities Utilities: Equity preferences, US Equities Energy: Equity Preferences, and US Equities MLP and Energy Infrastructure: Equity preferences.
Source: UBS